WACC Problem 1
1)Amount of equity = $ 1 billion
Amount of long term debt (first layer) = $ 3 billion
Amount of long term debt (second layer) = $ 2 billion
Total amount of capital = $1 billion + $3 billion + $2billion = $6 billion
Weight of equity = ($1billion/$6billion) = 16.67%
Weight of long term debt (first layer) = ($3 billion/$6 billion) = 50%
Weight of long term debt (second layer) = ($2 billion/$6 billion) = 33.33%
Cost of equity = 12%
Cost of long term debt (first layer) = 6%
Cost of long term debt (second layer) = 8%
It is assumed that all the above costs of instruments is post tax.
WACC = (0.166712%) + (0.56%) + (0.3333*8%) = 7.67% p.a.
2)The expected return from the proposed project based on DCF is 7%. On financial basis, this project should not be accepted. This is because the expected return of 7% is lower than the WACC of 7.67%. Hence, the project would have a negative NPV (Net Present Value) and would lower the value of the firm if accepted.
3)If the project returned 10%, then the project would be recommended on financial grounds. This is because the expected return on project at 10% would exceed the WACC of 7.67%. Hence, the project would have a positive NPV and would increase the value of the firm if accepted.
4)If the proportion of debt and finance remains the same as currently indicated on the balance sheet, then the project must have a return of atleast 7.67 p.a. to be accepted. This is the same as WACC. At this return value, the acceptance of firm would not add any value to the firm. For any higher return than 7.67% p.a., the NPV would be positive and the project would be easily accepted.
WACC Problem 2
a)The expected return associated with the 80% capacity is indicated below.
WACC for 80% capacity = 0.56% + 0.510% = 8% p.a.
Expected return for remaining capacity i.e. 20% = 10% p.a.
Hence, new WACC = 0.88% + 0.210% = 8.4% p.a.
b)The minimum rate of return from the expansion should be equal to the WACC at the time of expansion. This is because if the expansion would return a lower value, then the NPV would be negative and the firm value would decline. The computation of WACC is indicated as follows.
Weight of debt = 50%
Weight of equity = 50%
Cost of debt (assumed post tax) = 6%
Cost of equity = 10%
WACC = 0.56% + 0.510% = 8% p.a.
Hence, the minimum return for expansion to be financially feasible is 8% p.a.
WACC Problem 3
1)It is known that additional capital expenditure for the diagnostic machine would be done through debt which has a weighted average cost of 5%. It is expected that the investment would produce a return of 30%. Since the expected return from the incremental $ 2 million investment exceeds the cost, hence the provider organization should make this investment.
2)If the decision to invest elsewhere is made, then the amount of capital available would be 30% of $100 million or $30 million.
3)The relevant formula to be applied for computation of Sustainable Growth Rate (SGR) is illustrated as follows.
SGR = Retention Rate * Return on Equity
Return of equity = 10%
Retention Rate = (1-30%) = 70%
Hence, SGR = 0.7*10% = 7%
The organisation can grow at a SGR of 7% p.a.
